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April 5, 2012

Trading Volatility

The markets set many records for volatility in 2011. The extremes in volatility surprised even the most seasoned market veterans. Interest in trading volatility itself has grown, and as you might expect, many new products have been created and marketed to meet this demand. This has resulted in a large number of choices for the trader who wants to trade volatility itself.

Options on the VIX have been available for several years and have been growing in popularity, and we also have the VIX futures contracts. Some of the newer products include the volatility ETFs (exchange traded funds) and ETNs (exchange trade notes) that may be directly or inversely proportional to changes in volatility. But many of these products have more complex relationships, designed to magnify or leverage volatility moves; TVIX is an example of one of these leveraged volatility products. Personally, I am wary of all leveraged ETFs, whether based on volatility, commodities or market indexes. They very often do not live up to their projected leverage. Like TVIX, the internal mechanics to create the leverage are complex and can be somewhat unpredictable.

VXX is an ETF built out of VIX futures. It consists of a mixture of the first and second months out, so there is a continual rolling of the futures contracts forward. Traders use this fund to speculate on future values of VIX. If the overall market is trending upward, each futures contract will tend to trade at a higher price as we go out in time. In a bear market, the opposite occurs, and prices decline as we move out in time.

So the trader who wishes to trade volatility has a multitude of choices; but understanding and sorting out these products can be challenging. In my opinion, if you want to trade volatility, the simplest and most secure way is to trade the VIX options (buy calls or puts, or use spreads). If you want to learn more about these volatility products, I recommend the recent book by Russell Rhoads, Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes.